Over the past few months there has been some concern in the markets, not just about the sustainability and volatility associated with its powerful increase in recent months, but also about who is doing all this trading. Normally, investor ownership data are filed with the Securities and Exchange Commission on a lagged basis in the form of 13D filings, which is a notification that an investor holds more than 5 percent of any class of a companys shares. Ownership and trading, however, are two different things. As such, there has been growing interest about “dark-pool trading” and “high-frequency trading.”

I recently spoke with Bernie McSherry, a senior vice president of strategic initiatives at Cuttone & Co., where he is a member of the management committee involved with strategic planning and market strategy. He has served in a number of leadership positions within the industry and has chaired several New York Stock Exchange committees and served as the NYSE governor for six terms.

Question: Bernie, in simple terms what are dark pool trading and high-frequency trading, how long have they been around and what do they mean for the market?

Answer: In 2005, the SEC issued Regulation NMS, which mandated revolutionary changes in stock market structure and effectively forced manual exchanges such as the New York Stock Exchange to permit direct electronic access to the point of sale. As a result, the markets have become fragmented and traditional stock markets have seen a dramatic decline in their share of trading due to the proliferation of dark pools and computerized trading strategies.

Dark pools are alternative trading systems in which participants execute orders anonymously without public price disclosure until well after the trade has been consummated. Large institutions such as mutual funds and hedge funds prefer to mask their trading patterns from outside view and, as a result, they are increasingly turning to dark pools as replacements for traditional stock exchanges. There are concerns that the proliferation of dark pools has fragmented the market and has led to less-efficient pricing.

Many firms use high-frequency trading to exploit minute shifts in stock prices by using automated programs to repeatedly trade retail-size orders through ultra-high-speed data lines. Those strategies have become so popular that they are currently estimated to account for more than 70 percent of all U.S. trading volume. Unlike traditional shareholders, the average life of stock ownership by high-frequency traders is typically measured in seconds and there are indications that long-term investors are being disadvantaged as high-frequency traders employ strategies that are divorced from estimates of underlying corporate valuation.

Q: What is a “flash order” and why is it controversial?

A: High-frequency traders are heavy users of flash orders which selectively disclose trade information to the other party - either buyer or smaller - before the execution of a trade. Supporters argue that this practice can lead to price improvement for the initiators of trades, while critics point out that flash orders allow a privileged few to step in front of publicly displayed orders. The SEC has recently proposed a ban on the practice.

Q: What kind of an impact has all this had on the stock market?

A: By some accounts, high-frequency trading makes up well over two-thirds of all trading volume, and some firms are reaping spectacular profits from such strategies. High-frequency traders argue that narrow trading spreads and adds liquidity to markets, while detractors note that HFT takes place in stocks that are already liquid and that they profit at the expense of long-term investors. One of the biggest changes has been the effort by many firms to move their trading computers as close as possible to trading centers to reduce the amount of time it takes for their orders to arrive at the market venue.

Q: Are these developments helpful or hurtful to the individual investor?

A: Some individual investors have benefited by trading electronically through firms that provide low-cost electronic access to the market, but that is not the whole picture. Individuals who employ limit orders and those who invest through mutual funds are almost certainly disadvantaged by rules that permit an uneven playing field to exist. In addition, by favoring the interests of short-term traders ahead of those of long-term investors, our existing market structure will ultimately raise the cost of capital for American corporations and reduce their global competitiveness.

Q: What should be done?

A: Rather than address these issues through a series of piecemeal changes, the SEC should immediately undertake a sweeping re-evaluation of our stock markets to ensure that we dont erect new rules atop a flawed regulatory foundation. In the currently fashionable spirit of not letting a serious crisis go to waste, we should view the upcoming period of regulatory reassessment as a unique opportunity to redress the serious structural flaws that have unfairly disadvantaged long-term investors. That’s an effort we would all do well to invest in.

Chris Versace is director of research at Think 20/20 LLC, an independent research and corporate access firm based in Reston. He can be reached at cversace@washingtontimes.com. At the time of publication, Mr. Versace had no positions in companies mentioned. However, positions can change.